Keynes and the Classics – Part 4

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013. Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.
I am currently working on Chapter 11 which opens like this:

Chapter 11

11.1 Introduction and Aims

In Chapter 10, we discussed issues relating to labour market measurement. In this Chapter we will focus on theoretical concepts that underpin the measurement of economic activity in the labour market and the broader economy.

The Chapter has five main aims:

To explain why mass unemployment arises and how it can be resolved.

To develop the concept of full employment.

To consider the relationship between unemployment and inflation – the so-called Phillips Curve.

To develop a buffer stock framework for macroeconomic management (full employment and price stability) and compare and contrast the use of unemployment and employment as buffer stocks in this context.

To more fully explore the concept of a Job Guarantee (employment buffer stock) approach to macroeconomic management.

NOTE:

The series so far is:

Keynes and the Classics – Part 1 – explains how the Classical system conceived of labour supply and demand and how these come together to define the equilibrium level of the real wage and employment.

Keynes and the Classics – Part 2 – explains how the labour market determines the level of employment and real wage, which in turn, via the production function set the real level of output.

Keynes and the Classics – Part 3 – tied the previous conceptual development into the denial that there could be aggregate demand failures (Say’s Law), introduced the loanable funds market and discussed the pre-Keynesian critique (Marx) of the Classical full employment model.

Today, we consider the strategy that John Maynard Keynes took to demolish the Classical theory of employment and to outline why involuntary unemployment was the normal tendency of a capitalist (monetary) economy.

Keynes’ critique really defined the field of macroeconomics as a separate field of study in its own right by showing how “aggregated” microeconomics fell prey to logical flaws (fallacy of composition).

NEW TEXT STARTS TODAY HERE

11.13 The existence of mass unemployment as an equilibrium phenomenon

At the outset, the debate between Keynes and the Classical view in the 1930s expressed by the British Treasury (which became known as the Treasury View) centred on whether a person could become involuntary unemployed.

The “Treasury View” denied the existence of involuntary unemployment and argued that fiscal policy (government spending) could not enhance national prosperity by creating employment.

The orthodox Treasury view, and after all British finance has long been regarded as a model to many countries, is that when the Government borrow in the money market it becomes a new competitor with industry and engrosses to itself resources which would otherwise have been employed by private enterprise, and in the process it raises the rent of money to all who have need of it.

You will readily associate this with our discussion in the previous section of the Loanable Funds doctrine. In Chapter 17, we consider the modern debates in macroeconomics in more detail and you will readily see that the so-called crowding out objections against the use of fiscal policy, that are entertaining in the current era are based on this Treasury View. In fact, the current attack on the use of fiscal policy to increase employment growth reflects the conservative position put forward in the 1920s and 1930s, which we have characterised as the Classical employment theory.

… the orthodox Treasury doctrine … has steadfastly held that, whatever might be the political or social advantages, very little additional employment and no permanent additional employment can in fact and as a general rule be created by State borrowing and State expenditure.

As we saw in Section 11.X, the orthodox approach led to the conclusion that any enduring unemployment (beyond the frictional level) was caused by real wages being above the equilibrium level, principally because money wages were downwardly rigid.

[NOTE: The 1929 Budget was labelled an “election budget” yet the conservative government lost the election that was held soon after it was delivered. In the face of rising unemployment, the British people rejected the argument that the government was powerless to increase employment]

The Classical (orthodox) cure for unemployment was simple – allow money wages to fall in the face of the excess supply of labour – so that the real wage could adjust to the “full employment” productivity level. The only role for government in this process was to ensure that wage flexibility was possible.

John Maynard Keynes disputed this reasoning and outlined a new approach to the labour market, which provided an explanation for mass unemployment that was independent of whether wages were flexible or not. In other words, he set out to show that the existence of mass unemployment was not related to the question of wage flexibility.

In the historical context, this contention was considered to be revolutionary as it challenged the intellectual supremacy of the conservative economists, who held sway in government.

In developing his explanation for the existence of involuntary unemployment, Keynes sought to show that mass unemployment arose as a result of systemic failures, which left individuals powerless to improve their own circumstances.

As a precursor to understanding the specific way in which Keynes developed his new theory, it is important to consider two broad concepts of equilibrium that can be found in the literature.

In the Classical employment model, we see that equilibrium is commensurate with a point where supply equals demand. It is also construed as being a point at which the economy will remain at rest if no disturbances to supply or demand occur. The first construction follows from the second.

Unemployment therefore, in the Classical employment theory, is a dis-equilibrium phenomenon, and will be eliminated as real wage flexibility restores the demand and supply equilibrium.

The only way the dis-equilibrium could persist is if, for example, the government imposed rigidities on the labour market (say, a minimum wage) that held the real wage above the full employment level. Otherwise, the flexible price labour market would always ensure the full employment equilibrium was sustained.

The concept of involuntary unemployment that Keynes introduced into the literature was consistent with the concept of equilibrium as being a state of rest. But it was in sharp contradistinction to the idea that equilibrium also required a balance between demand and supply.

In other words, he advanced an argument that said that mass unemployment was an equilibrium state that the capitalist monetary economy tended towards and could remain in that state indefinitely without government intervention.

Therefore, the Classical approach saw unemployment as a temporary disequilibrium state, which would be soon corrected as real wages adjusted to the demand and supply imbalance, whereas Keynes saw unemployment as being an equilibrium state, which would persist unless effective demand was stimulated.

This distinction also influences the way Keynes defined full employment. For the Classical economist in the 1920s, full employment occurred whenever labour demand and labour supply were equal, irrespective of the level of employment that coincided with that balance. As you will recall, they denied the existence of unemployment so that even if the employment level achieved was well below the current labour force, they would consider the difference to reflect voluntary choices by workers not to work.

For Keynes, full employment was a special point that required that effective demand (total spending) was sufficient to ensure that there were enough jobs offered to match the willing labour supply at the current money wage level. It was a state that the capitalist system might achieve (as a special case) but there was no general tendency within the dynamics of the system to move the economy to this state.

11.14 Keynes critique of Classical employment theory

In the General Theory of Employment, Interest and Money, Keynes sought to show that the Classical theory failed to provide a satisfactory explanation for the existence of mass unemployment. He also rejected the principle policy proposed by the “Treasury View” that money wages should be cut to solve unemployment.

Keynes also argued that even if real wage flexibility was possible, the economy could still tend to and persist in a state of mass unemployment. In other words, he sought to demonstrate that the existence of mass unemployment was not related to whether real wages were flexible or not. As a matter of policy, as we will explain later, Keynes thought that the existence of money wage rigidity and the institutions that supported it was a preferred state. But he was at pains to show that unemployment was not caused by that institutional structure.

In Chapter 2 of the General Theory, Keynes introduced what he called the “two fundamental postulates” of Classical economics (that is, the “Treasury View”):

i. The wage is equal to the marginal product of labour

ii. The utility of the wage when a given volume of labour is employed is equal to the marginal disutility of that amount of employment.

[Source: Macmillan version GT, 1936, page 5]

You should ensure that you can relate these “postulates” with the discussion in Section 11.6. The first postulate describes the Classical labour demand theory where profit-maximising firms employed up to the point where the real wage they paid to the last worker hired was exactly equal to the marginal productivity of that worker.

The second postulate relates to the Classical supply of labour theory that workers choose between work and leisure. The former provides income, which allows the worker to derive satisfaction (“utility”) from the purchase of goods and services, but also is considered bad (“a disutility”) because it diverts workers from enjoying leisure.

The price of leisure is the real wage and workers ensure that the number of hours of work they supply equalises the good derived from work with the bad.

While Keynes ultimately showed that the real wage and total employment level were not determined in the labour market, as in the Classical theory of employment, he still had no objection to the first postulate as a representation of a competitive economy. Later in the Chapter we will see that his acceptance of the first classical postulate was not without problems.

His main motivation, in accepting the first postulate, was to divert the focus of his critique on the supply side of the labour market, which he considered was the source of Classical failure to understand how involuntary unemployment could arise as a normal tendency of the Capitalist monetary economy.

Keynes had two objections to the second classical postulate – one which he said was “not theoretically fundamental” (REFERENCE) and the other which he described as being “fundamental”.

He thus considered this postulate did not accord with the real world behaviour of workers, which, in empirical terms, suggested that workers behaved in an asymmetric way to real wage reductions, depending on whether they were motivated by money wage reductions or a rise in the general price level.

He argued that workers would withdraw their labour services if money wages were cut (and real wages fell) but would not respond in this way, if an equivalent real wage cut resulted from the price level rising. In other words, as a general case, it is observed that workers do not necessarily withdraw their labour services when the real wage falls. It all depends on what motivates that reduction.

Recall that the real wage is a ratio of the money wage and the general price level. Keynes argued that the “classical school have tacitly assumed that this would involve no significant change in their theory” (GT, 1936, page 8).

The clue to understanding his argument was to note that the Classical model assumed that labour supply was a function of the real wage exclusively (see Figure 11.4). However, in the real world, workers are also concerned with the level of money wages as well as the purchasing power equivalent of the same (the real wage).

The Classical response to this critique was to claim that it is irrational or illogical for workers to suffer from what they called “money illusion”. That is, why would workers care about the nominal value of their wage. Surely, it is only the real wage that matters because their decision to supply labour was to acquire real goods and services from the income they earned?

Keynes response was telling. First, he noted that while a rise in the general price level affected all workers, money wage cuts would be typically applied to certain segments of the workforce (where unemployment was concentrated). Research confirms that workers are influenced by their relative place in the wage structure, given that wages are one way in which we measure social status. One’s money wage is more visible to others than the more ambiguous concept of the real wage.

At parties and other social milieu, we informally judge each other by the income levels that we receive. These are concerns that the Classical model ignores.

If a worker in a particular industry was to accept a money wage cut when that industry was enduring a downturn in demand for its output, then they would be downgrading their position in the wage structure. They would also form the view that their relative position in the wage structure would not be reversed when the economy improved again. As a result, these workers will resist a money wage cut.

However, they will not necessarily resist a real wage cut (of the same implied magnitude as would result from the money wage reduction) arising from a rise in the general price level because this would impact on all workers and the relative positions in the wage structure would be maintained. They would all be worse off but not in relative terms.

While the Classical approach ignored the richness of social institutions, thinking of them as ephemeral rigidities standing in the way of competitive outcomes which would disappear under the force of competition in the long-run, economists like Keynes understood the value of institutions. This made it easy for him to understand that it was perfectly logical or rational for a worker to be concerned about social standing (relativities).

Keynes also understood that trade unions were important institutions in a Capitalist economy, which protected the place of workers in the income distribution. He wrote (GT, 1936, page 14) that:

Every trade union will put up some resistance to a cut in money-wages, however small. But since no trade union would dream of striking on every occasion of a rise in the cost of living, they do not raise the obstacle to any increase in aggregate employment which is attributed to them by the classical school.

The second reason why workers would resist money wages relates to the financial arrangements that workers enter into in the normal course of their lives. A major commitment that many workers enter is the purchase of their homes. Further, workers use credit to smooth their consumption expenditure over time. These contractual commitments are always specified in nominal (that is, money) terms. For example, a worker has to pay a certain quantity of dollars per month to service their home mortgage.

In other words, the solvency of the workers is a nominal concept. If they cannot get sufficient money each period to service their nominal contractual commitments then they are in trouble.

In this context, if the general price level rises and the real value of their money wage declines, for a time, they are able to change their budget allocations (perhaps eliminate some non-necessary items of expenditure) and still maintain their nominal contractual obligations. At some point, this becomes impossible but within the usual variations in the real wage this is how households cope.

However, if the real wage was to be adjusted via reductions in the money wage, workers might find they do not have enough money income in a period to service their contractual obligations and they would then have to default and face insolvency.

Clearly, it is rational to resist that eventuality and thus workers care not only about the real wage they are able to earn but also the level of money wages that they receive.

However, Keynes did not consider these institutional objections to be fundamental to the theoretical veracity of the Classical employment model. He described his second major objection as being a “more fundamental objection” – that is, it attacked the theoretical basis of the Classical explanation of unemployment.

… from the idea that the real wages of labour depend on the wage bargains which labour makes with the entrepreneurs … it is the money-wage thus arrived at which is held to determine the real wage. Thus the classical theory assumes that it is always open to labour to reduce its real wage by accepting a reduction in its money-wage.

The Classical model characterises the interaction between labour demand and supply as being mediate by movements in the real wage, yet in the real world it is the money wage that is agreed in the labour market.

Thus, workers apply for jobs, which specify a certain money wage that will be paid. In some cases, workers negotiate the money wage they are prepared to accept. The point is that the so-called labour market contract that leads a worker taking a job with some employee leads to some money wage being paid to the worker. It might be $15 per hour or $80,000 per year or whatever.

To argue that unemployment is voluntary and can be solved by a reduction in the real wage assumes that workers have volition and can engineer the appropriate real wage cut by accepting lower money wages. This would require “that the wage bargains between the entrepreneurs and the workers determine the real wage” (page 13).

Keynes disputed the claim (GT, 1936, page 13):

… that the general level of real wages is directly determined by the character of the wage bargain. In assuming that the wage bargain determines the real wage the classical school have slipt in an illicit assumption. For there may be no method available to labour as a whole whereby it can bring the general level of money-wages into conformity with the marginal disutility of the current volume of employment. There may exist no expedient by which labour as a whole can reduce its real wage to a given figure by making revised money bargains with the entrepreneurs. [emphasis in the original]

[NOTE: IN ORIGINAL IT IS ITALICS AND SHOULD BE SO IN THE FINAL TEXT – HERE I USED BOLD BECAUSE THE FORMAT OF THE BLOCKQUOTE TAG DOESN’T RENDER ITALICS]

Keynes believed that the Classical economists had fundamentally misunderstood how “the economy in which we live actually works” (page 13). In particular, he argued that if a money wage reduction occurred, it was likely to lead to lower prices because marginal costs would be lower (ignoring shifts in productivity due to issues relating to workforce morale).

Imagine that money wages fell by 5 per cent and the price level fell by 5 per cent, then the real wage would be unchanged. This was the basis of Keynes’ argument.

He wrote that the idea that money wage cuts would lead to real wage cuts was:

… far from being consistent with the general tenor of the classical theory, which has taught us to believe that prices are governed by marginal prime cost in terms of money and that money-wages largely govern marginal prime cost. Thus if money-wages change, one would have expected the classical school to argue that prices would change in almost the same proportion, leaving the real wage and the level of unemployment practically the same as before, any small gain or loss to labour being at the expense or profit of other elements of marginal cost which have been left unaltered.

[TO BE CONTINUED …]

Conclusion

Next week we will continue with the argument and introduce the criticism by Keynes of the Classical theory of interest (that is, the loanable funds doctrine). This allowed him to show how aggregate demand not only determined employment (and the real wage) but also could be deficient and lead to involuntary unemployment.

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:

“In other words, the solvency of the workers is a nominal concept. If they cannot get sufficient money each period to service their nominal contractual commitments then they are in trouble.

In this context, if the general price level rises and the real value of their money wage declines, for a time, they are able to change their budget allocations (perhaps eliminate some non-necessary items of expenditure) and still maintain their nominal contractual obligations. At some point, this becomes impossible but within the usual variations in the real wage this is how households cope.

However, if the real wage was to be adjusted via reductions in the money wage, workers might find they do not have enough money income in a period to service their contractual obligations and they would then have to default and face insolvency.”

In my book, the above statement is a bogus argument. In both cases, it simply depends on the degree of the relative wage change and shows equal effect when the wage change is equal.

Let’s consider a man earning $50,000 with a mortgage payment of $10,000, both on a yearly basis.

Case A: Reduction of wage by 20%. He will earn $40,000, leaving him 30,000 after paying for the mortgage. He therefore will have a reduction of his budget ex mortgage of 25%.

Case B: Prices increase by 25% (mathematically a reduction is taken from 100% and for comparison, we therefore have to see a 20% increase in prices starting at 80% and increasing to 100% to reach a comparable result which in this case means a 25% increase in prices). His budget ex mortgage remains at $40,000 with a reduced purchasing power of 25%.

“ignoring shifts in productivity due to issues relating to workforce morale”

This is an interesting statement as it does demonstrate your willingness to think outside the realm of aggregates. One aspect that definitely has a high degree of influence is certainly to be found in the degree of wage variations within the concerned company. If, for example, the CEO takes a wage that shows his disregard for the firms well-being and simply tries to enrich himself (even if it only has the appearance), it will generally result in a negative effect on most workers (with the exception of those close to the powerful position as they nurture the hope to get into the same position). A sensible business leader, however, will set an example by reducing his wage at a much higher degree in times of difficulties and producing as a result a community of fate which may improve morale considerably. I do not think that comparisons to other sectors or segments in the economy have any comparable degree of influence on morale.

You are very knowledgable in the field of economics and must have read countless thesis. I therefore would like to ask you whether there exist any studies on the subject of the effect that continuous increases in the level of prices has on society. I value any references to this subject.

Sorry, I have to correct myself in the above explanation regarding the status bogus argument as after reviewing the matter, the loss of purchasing power on the budget would actually be 20%.

Nevertheless, let me make another point in this regard. What this policy of general price increases also does, is redistribute wealth from those who have no debt to those that assumed debt. When viewed in a wider perspective, this situation develops into the idea that the acquisition of as many as possible physical assets with as high as possible a leverage (own capital to debt) will result in a extraordinary profitable proposition. This is certainly one of the boosters for the building of bubbles that produce hardship and damage to the society, once one of those bubbles bursts.